For most individuals, retirement accounts such as 401(k)s and IRAs are their largest asset to draw upon during retirement. The average 401(k) balance in 2025 for those over 65 is ~$426,000. According to Fidelity, there are 497,000 401(k)s and 398,593 IRAs at Fidelity with a balance of at least $1 million.

A commonly asked question is: What happens to the money when the account owner dies? Unfortunately, there isn’t a straightforward answer. The passage of the SECURE Act permanently changed the rules for many who inherit IRAs. Factors such as the account owner’s age upon passing, the year of passing, and the beneficiary’s relationship to the account owner play a role. One thing is clear: Assets in an inherited IRA cannot be left in the account forever.

SECURE Act

The passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2020 and its latest revision, SECURE 2.0, drastically changed the rules for many who inherit IRAs. It is imperative to understand the options to avoid creating a potentially large tax liability.

Let’s start with those who inherited an IRA prior to the SECURE Act. For these individuals, the options are more straightforward.

Lump sum: Beneficiaries can take the entire balance as a one-time IRA distribution. The amount is taxed as ordinary income, which subjects the beneficiary to a higher tax bracket.
Stretch IRA: Beneficiaries can transfer the funds into an inherited IRA and “stretch” the distributions over their lifetime, which helps minimize the tax burden. The annual required minimum distribution (RMD) rules are based on the beneficiary’s life expectancy, allowing the account to grow over the long term.
Spousal IRA: Spouses have the most flexibility and can transfer the funds to an inherited IRA or their own IRA. Most choose the latter, as that defers any mandatory withdrawals until reaching the required minimum distribution age, even if their spouse was of RMD age, thus saving taxes and allowing the account to grow. As a rule of thumb, spouses who transfer the funds to an inherited IRA generally do so if they are under age 59½ and need access to the account for daily living expenses. This option avoids the 10% early withdrawal penalty that would otherwise be assessed on withdrawals from their own IRA. Once the spouse reaches 59½ or no longer needs access to these funds, the amount can be transferred to the spouse’s IRA.

With the passage of the SECURE Act, the rules drastically changed, mainly for non-spouse beneficiaries. The lump sum and spousal IRA options remain, but the ability to stretch distributions over the beneficiary’s life expectancy was mostly eliminated.

Instead, non-spouse beneficiaries must liquidate the entire account by December 31 of the 10th year following the year of the original account owner’s death, known as the 10-year rule. The only exception is if they qualify as an eligible designated beneficiary (EDB)—more on that below.

In addition, beneficiaries may also be required to take annual RMDs depending on the age of the original account owner:

No annual distributions are required if the original account owner was under RMD age.
If the original account owner started taking RMDs, beneficiaries must also take them annually based on their own life expectancy. RMDs must commence on December 31 of the year following the original account holder’s death. If a minor inherits the account, the first RMD must be taken by December 31 of the year of their 21st birthday.

Given the confusion with the new RMD rules, the IRS stated there will be no penalties for beneficiaries (covered under the proposed 10-year rule) who failed to take one in 2024. This extends the previous guidance that removed the penalties for 2021, 2022, and 2023. Starting in 2025, any missed RMDs face a 25% penalty, though the amount can be reduced to 10% if the shortfall is corrected and Form 5329 is filed within two years.

As mentioned, eligible designated beneficiaries can “stretch” their inherited IRAs over their lifetime. The following fall under this category:

Surviving spouse
Disabled or chronically ill individual
An individual who is not more than 10 years younger than the IRA owner
Child of the IRA owner who has not reached the age of majority

In addition, certain trusts named as an IRA beneficiary can be considered EDBs.

A common mistake for beneficiaries is failing to check if they qualify as an EDB. For those who don’t, inheriting an IRA can lead to a massive tax event if not handled properly. Working closely with a financial advisor can help avoid these costly mistakes.

Far too often, beneficiaries either cash everything out in year one or postpone withdrawals until the final year. While both options are allowed, waiting until the end will likely lead to an extremely higher-than-necessary tax bill, as this decision ignores the compounding effect of investments. Let’s look at an example:

Tim, who is single, inherits an IRA from his father worth $150,000. Let’s assume Tim is not subject to annual RMDs and decides to wait until the end of year 10 to withdraw the entire inherited IRA. Assuming an 8% annual growth rate, the account would be worth ~$332,946. This amount alone would place Tim in the second-highest federal tax bracket (35%). With proper planning, Tim could have mapped out an annual withdrawal strategy and paid significantly fewer taxes along the way.

What if Tim was retired when he cashed out his inherited IRA? While he may not have other sources of income and save himself from the 35% bracket, Tim could open himself to consequences such as Medicare Part B surcharges (IRMAA), a higher capital gains tax rate, and net investment income tax (NIIT). In addition, the decision could derail strategies like Roth conversions or 0% capital gains for that year.

This entire post so far has addressed inherited IRAs. What about inherited Roth IRAs? Well, those work a little differently. While still subject to the 10-year rule, the distributions remain tax-free. (Roths inherited before the SECURE Act can still be stretched over the beneficiary’s life expectancy.)

When inheriting money, especially retirement accounts, you need to be extremely careful to avoid paying unnecessarily higher taxes. Working with a financial advisor can help you navigate through this process and avoid the common pitfalls many fall prey to. Losing a loved one is already hard enough, but compounding that with paying an unnecessarily high tax bill can be avoided.

Feel free to discuss your situation with our financial planning firm.

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